To reduce this informational asymmetry, issuers tend to hire underwriters and to use a
“Bookbuilding mechanism”. This common practice of Bookbuilding consists on setting a
preliminary offer price range by the issuing firm, then the underwriter will take the role of
trying to collect private information from investors about the offering which is called
“indications of interest” such as their demand, the price they are willing to pay to acquire the
IPO shares… The bookbuilding mechanism allows underwriters to extract this private
information. During pre-selling period, the underwriter tries to gauge demand and to have an
idea about the price that potential investors are willing to pay, these indications are then used
in setting the final offer price. If there is strong demand and the investors are willing to pay a
higher price to obtain the IPO stocks, the underwriter will set a higher offer price and viceversa.
But, Ritter and Welch (2002) add that if potential investors know that showing a
willingness to pay a high price will result in a higher offer price, these investors must be
offered something in return. They have to be rewarded for communicating favourable
information. Otherwise, if these investors are offered nothing in return and the issuing firm
will go public with a higher offer price, investors are dissuaded and they will not reveal their
intentions and may even try to reveal wrong information to bias the underwriter’s decision.
So, to induce investors to truthfully reveal that they want to purchase shares at a high price,
underwriters must offer them some combination of more IPO allocations and underpricing
when they indicate a willingness to purchase shares at a high price : Benveniste and Spindt
(1989), Benveniste and Wilhelm (1990), and Spatt and Srivastava (1991).
Lee, Taylor, and Walter (1999) and Cornelli and Goldreich (2001) show that informed
investors request more, and preferentially receive more allocations.
For the issuer, underpricing is on one hand compensation to the underwriter: Baron (1982)
has the same theory which is based on the fact that issuers are less informed than
underwriters, they delegate the pricing decision to underwriters who possess superior
information regarding the demand for the IPOs, and to induce the underwriter to requisite
effort to market shares, it is optimal that issuer lets some underpricing because he can not
monitor the underwriter without cost. However, we should point out the findings of
Muscarella and Vetsuypens (1989) that when underwriters themselves go public and then
there is no monitoring cost, their offerings are also underpriced. So underpricing is a
necessary cost of going public and not a monitoring cost as advanced by Baron.
On the other hand, underpricing is compensation to investors to truthfully reveal their
willingness to purchase the IPO shares and with a higher price.
But we should also mention the fact that underwriters should not underprice too much to not
lose business from issuers. Nanda and Yun (1997) find that high levels of underpricing lead to
a decrease in the lead underwriter’s own stock market value, whereas moderate levels of
underpricing are associated with an increase in stock market value.
In a similar sense, Dunbar (2000) finds that banks subsequently lose IPO market share if they
either underprice or overprice too much.
As a conclusion for the information revelation theory, we can say that underpricing can be
reduced by reducing the informational asymmetry between the IPO parties.
And as Ritter and Welch (2002) note, if underwriters used their discretion to bundle IPOs,
problems caused by asymmetric information could be nearly eliminated.
Underwriters, are intermediaries between issuer and investors, they advise the issuer
on pricing the issue, both at the time of issuing a preliminary prospectus that includes a file
price range, and at the pricing meeting when the final offer price is set. In the bookbuilding
period, they try to collect the investors’ private information which can help in setting the price
and even the volume of IPO shares. Their role is very important in reducing the information
asymmetry by transmitting the investors’ private information to issuers. So, the revelation
information theory is based on the work of underwriters.
I presented in the previous paragraph that underpricing is positively associated with
underwriter reputation. For example, consistent with evidence from the 1990s (Beatty and
Welch (1996)), Ljungqvist, Nanda and Singh (2004) predict that underpricing increases in
underwriter prestige, but that this relation depends on the state of the IPO market.
Also, Benveniste, Ljungqvist, Wilhelm and Yu (2003) find a positive relation between
underpricing and underwriter prestige in the 1999-2000 hot market.
First, we should present the measures used of underwriter reputation: Carter and Manaster
(1990) provide a ranking of underwriters based on their position in the ‘tombstone’
advertisements in the financial press that follow the completion of an IPO. This ranking, since
updated by Jay Ritter, is much used in the empirical IPO literature, it is a discrete underwriter
reputation measure ranging from 0 to 9, where a 9 (0) represents the most (least) prestigious
underwriter.
Megginson and Weiss (1991) measure underwriters’ reputation instead by their market share,
and this approach too is widely used.
The fact of using a prestigious underwriter in the bookbuilding process has an impact on
signalling the high quality of the issuing company as I said earlier, but it has also a great
impact on the information revelation, since prestigious underwriter is a source of confidence
to investors. The prestigious underwriter has a great ability and power to make investors
reveal their private information.
Many explanations were presented to the positive relation: when an issuer decides to hire a
prestigious underwriter, he is sure about a full subscription, he is concerned by quantity rather
than price, and by setting a low offer price, he tries to increase the probability of full
subscription. There are some other issuers who are concerned by their firm quality and by
hiring a prestigious underwriter, they tend to demonstrate their high quality and they set a low
offer price as a signal of quality and of the real value of the company. From the point of
informational revelation theory, underpricing and underwriter reputation are positively related
because underpricing is used as compensation to the underwriter (Baron 1982).
In Loughran and Ritter (2004) model, top-tier underwriters are associated with more
underpricing in the 1990s, and especially in the bubble period.
Loughran and Ritter (2003) argue that prestigious banks have begun to underprice IPOs
strategically, in an effort to enrich themselves or their investment clients. Another explanation
is that top banks have lowered their criteria for selecting IPOs to underwrite, resulting in a
higher average risk profile (and so higher underpricing) for their IPOs.
But the relation between underwriter reputation and underpricing is not systematically
positive and it is empirically mixed, there are some researchers who find that the correlation
between underpricing and underwriter reputation is negative: when an issuer hires a
prestigious underwriter, he can set a higher offer price and then lower underpricing will be
observed. For example, Carter and Manaster (1990), and Carter Dark and Singh (1998) find
that more prestigious underwriters are associated with lower underpricing.
There are also some researchers who have introduced the underwriter reputation variable in
their models and find that it is statistically insignificant as in Guo, Lev and Shi article (2006).
These authors have introduced the underwriter reputation as an explanatory variable to
explain underpricing and find that it is statistically insignificant.
In practice, results are not very sensitive to the choice of underwriter reputation measure, but
they are highly sensitive to the period studied.